Profitability on the IFRS basis

The UK Life & Pensions result before one-off items has decreased by 25% from £79m to £59m, primarily due to a decrease in profit arising from protection business. This is a consequence of a review of our DAC amortisation for protection business following PS06/14 reserving changes. We have accelerated the amortisation of this DAC because of the earlier recognition of margins. As a result of this, together with higher pensions sales, new business strain has increased from £(102)m to £(125)m. In-force surplus has increased slightly to £184m.

The widening of corporate bond spreads on assets primarily backing annuities has had an adverse £90m impact on IFRS profit. This arises because prudent valuation rules prevent the annuity liabilities from being valued in line with the currently high yields on the matching assets. The matching assets are marked to market. These assets are generally held to maturity and this adverse impact will be recovered over time unless there are asset defaults. In addition, one-off items of £(40)m include an injection of £22m into policyholder funds and arises from a review of unit-linked fund charges on first adoption of the ABI best practice guide. In 2006 one-off items of £(33)m included a reduction in the value of DAC.

Protection sales are 5% down measured on the APE basis. Both the cash strain and the in-force surplus have been significantly reduced by the implementation of PS06/14 and the consequent creation of negative reserves.

Pensions APE sales increased by 24%, which has caused the higher cash strain. The cash in-force surplus has increased due to the impact of increases in fund values on management charges. The surplus grows at a greater rate than the growth in funds under management because of the gearing effect caused by mainly fixed maintenance expense levels.

Annuity APE sales increased by 7%. Cash generation was slightly lower at £15m with the effects of reinsuring the post-demutualisation in-force annuity book being largely offset by lower new business strain arising from interest rate movements.

Savings & investments APE sales fell by 27%. The savings & investments cash strain is at a similar level to 2006 through a reduction in future cash flows recognised. The increase in the With-Profits Fund surplus is driven by higher bonus costs, due to higher maturities, and higher management charges, more than offsetting the run-off of the business.

Following implementation of PS06/14 reserving changes, margins now emerge at commencement such that there is effectively no deferral of protection acquisition costs. This change has been reflected as from 1 January 2007. The deferred acquisition costs for pensions and savings & investments business reflects the relative level of new business written in the year. The amortisation over the year is carried out on a straight-line basis for investment business and in line with the run-off in value of in-force business on an EEV basis for all other categories of business.

The International Life & Pensions result before one-off items has reduced from £38m to £15m, primarily as a result of higher new business strain and lower in-force surplus in FPI. FPI new business strain has increased primarily due to increased volumes and changes in the mix of new business. The FPI in-force surplus in 2006 included a £15m misclassification relating to PS06/14 benefit. The one-off item in 2007 represents an adjustment to remove reserves no longer required. The 2006 one-offs were mainly in respect of changes in actuarial funding in FPI.

FPI cash strain has increased significantly due to a combination of factors. Firstly FPI sales on the APE basis have increased by 60% since 2006. Secondly, a special offer was launched in April 2007 on Premier, a regular premium savings product, offering enhanced allocation, resulting in increased strain. Thirdly, increased commission levels reflected the success of the German pension offering. FPI in-force surplus has decreased because, as discussed earlier, the 2006 comparative included a misclassification of £15m. Lombard sales have decreased by 5% but new business strain has not reduced proportionately because of fixed acquisition expenses. Lombard in-force surplus has increased in line with funds under management.

The significant increase in new regular premium business within FPI resulted in a corresponding increase in the actuarial funding adjustment. The increase in DAC reflects the levels of business written. FPI new business volumes, particularly on regular premium business, increased substantially. Taken together, DAC and IFRS adjustments largely offset the increased cash strain. Lombard new business volumes fell slightly compared to 2006.

Return on Life & Pensions shareholders funds

Longer-term investment return has increased from £53m to £71m because of a 16% increase in the weighted average value of Life & Pensions shareholder assets during the year from £1,046m in 2006 to £1,219m in 2007 and a 75 basis points increase in assumed rates of return. The investment return on the corporate shareholder assets is included in Corporate items. The longer-term investment return rates assumed were: equities 8.00% (2006: 7.25%), gilts 5.00% (2006: 4.25%) and other fixed interest 5.50% (2006: 4.75%). For 2008, these rates of return will be unchanged.

Other UK Life & Pensions net income

Other UK Life & Pensions net income of £nil (2006: £nil) includes profits from the Sesame and Pantheon Financial IFA businesses of £12m and £2m respectively which were acquired during the year and have performed in line with expectations. The above results reflect seven months trading since the dates of acquisition. Sesame includes a £2m credit relating to the one-off release of a provision. These were offset by £14m costs incurred developing a Wrap platform. This development has now been terminated.

Asset management underlying profit

	2007 £m	2006 £m
Net revenue	265	248
Operating expenses	(184)	(159)
Other	1	2
	82	91
Operating margin	30.9%	36.5%
Other expenses (net)	(4)	(2)
Asset Management underlying profit	78	89

F&C Asset Management plc funds under management decreased marginally from £104.1bn to £103.6bn. Net fund outflows were £(9.0)bn, offset by £8.5bn positive movements due to the impact of rising markets and positive exchange variances. The net outflows included £(5.1)bn insurance, £(2.9)bn institutional, £(1.3)bn sub-advisory, offset by retail inflows. Net revenue has increased by 7%, mainly due to performance fees, which more than doubled to £21m. Revenue margin, measured as management fee income divided by average funds under management, has increased from 22 basis points in 2006 to 23 basis points in 2007. In part this reflects the loss of low fee mandates, but also reflects progress towards generating new business in higher margin areas.

Operating expenses, excluding certain share scheme costs, amortisation and impairment of intangible assets and restructuring costs, increased by 16%. During the year headcount rose by 138, with 81 arising from the transfer of staff on termination of the Mellon outsourcing agreement, and the remainder representing an investment in the business to support the enhanced product range and distribution plans. IT and operational costs also increased as a result of significant project costs associated with changes to the operating platform, both through the reintegration of the Mellon back office and the introduction of a new front office Decision, Risk and Dealing system. As a consequence operating margin has fallen from 36.5% to 30.9%, and underlying profit has decreased by 12%.

F&C launched its three-year plan last year, focused on targeting specialist areas and higher margin products to foster profitable organic growth. Good overall progress has been made in executing the first year of the plan. The focus of 2008 will be distribution, with a number of initiatives in place to extend its reach into new territories in Europe and beyond.

Corporate items

Corporate items of £(15)m (2006: £(14)m) comprise: expected return on net pension liability £8m (2006: £9m), expected return on corporate net assets of £(9)m (2006: £(10)m), and corporate costs of £(14)m (2006: £(13)m).

£20m management expenses previously categorised as development costs are now expected to be ongoing costs. This has a one-off £(112)m impact on IFRS profits as a result of increasing reserves to allow for the increased future costs and acceleration of amortisation of DAC.

In 2007 we implemented the second phase of PS06/14 Prudential Changes for Insurers. This lowered mathematical reserves resulting in a further one-off acceleration in the emergence of cash. However, the corresponding reduction in DAC, together with a review of the estimated amortisation profile, led to a one-off impact on IFRS profits of £(34)m. In 2008 we will reorganise our operations to allow recognition of further reserve reductions as a result of PS06/14, to deliver a final one-off cash acceleration of approximately £100m. The corresponding reduction in DAC is expected to leave IFRS profits broadly unchanged in this respect.

The reinsurance of the post-demutualisation annuity portfolio, implemented in the first half of 2007, has had a beneficial impact on cash and a positive impact on IFRS profits of £11m in line with expectations. The IFRS impact is lower than the cash benefit as more value had been recognised in earlier years under IFRS.

Other items

	2007 £m	2006 £m
Short-term fluctuations in investment return	(78)	(39)
Non-recurring items	38	(17)
Amortisation of acquired present value of in-force business	(26)	(25)
Amortisation of Life & Pensions acquired intangible assets	(11)	(7)
Amortisation of Asset Management acquired intangible assets	(42)	(43)
Impairment of Asset Management acquired intangible assets	-	(58)
Interest payable on STICS	52	52
Policyholder tax	23	124
Returns on Group controlled funds attributable to third parties	(23)	104
Other items	(67)	91

Other items reflect the differences between IFRS underlying profit and IFRS profit before tax from continuing operations. The main factors are:

• Short-term investment fluctuations represent the differences between actual and expected investment market returns. The charge of £(78)m reflects falls in fixed income security values offset by increases in equity values.
• Non-recurring items include £34m compensation received (net of costs) in respect of the aborted merger with Resolution plc, £15m credit in respect of the release of provisions less £(11)m other items.
• There is no impairment charge required in respect of F&C's acquired intangible assets. The charge in 2006 related to the write down in value of management contracts following fund outflows notified in the year.
• Within the calculation of the underlying IFRS result, STICS is accounted for as debt to reflect the economic reality. However, IFRS rules require that STICS should be accounted for as equity in calculating IFRS profit before tax and consequently STICS interest is added back and treated as an appropriation of profit.
• Policyholder tax is excluded from the underlying result as it is not attributable to shareholders. The decrease compared to 2006 is due to lower property and equity gains. The linked property gains are £283m lower and the linked life equity gains are £239m lower compared to 2006.
• Returns on Group controlled funds attributable to third parties mainly reflects the 47% minority interest in F&C Commercial Property Trust.

Management expenses

The expenses of the UK and International Life & Pensions businesses (excluding Lombard costs, development costs and non-recurring costs) are set out below:

The UK cost base has been tightly controlled in 2007, despite the overall growth in the size of the business. The International business has experienced growth in acquisition costs in particular, reflecting its significant growth in both existing and new markets.